Not all investment vehicles are built equally. They each have their own advantages, disadvantaged and optimal use cases. But when it comes to gaining exposure to an asset like Bitcoin, it’s often best to use the simpler and more transparent structure.
Most cryptocurrency investment vehicles are closed-end funds. Closed-end funds pre-date mutual funds by more than a quarter of a century, with the first debuting in the United States in 1893. The structure allows for a fixed number of shares issued via an IPO, with additional shares requiring additional issuances.
The newest vehicle for cryptocurrency, exchange-traded funds (ETFs), is much more novel. The first ETF debuted in Toronto in 1990. ETFs are open-ended, continuously offer shares and can be redeemed for the underlying investment. They have an elastic supply which can accommodate increasing demand. This differs greatly from closed-end funds, which have relatively inelastic supply that can be costly.
Bitcoin investing: Why structure matters
While the two structures have several differences, the big one is price behavior. ETFs can create and redeem shares intraday for the underlying asset(s), allowing the fund to track net asset value (NAV) closely. Closed-end funds have a net-asset value as well, but can trade at a substantial premium or discount to NAV for prolonged periods of time. On average, closed-end funds trade at a discount – something academics coined as the “closed-end puzzle.” What does this mean in the context of Bitcoin?
When an ETF purchases a basket of securities, the investor owns that basket of securities. Closed-ended funds add an additional layer as investors are actually purchasing a company that owns the securities. From an investor’s perspective, you now are subject to two price returns – that of the underlying assets of the closed-end fund and the closed-end fund itself.
Looking at a key closed-end fund in the Bitcoin space with over $1.1 billion in assets, we see how transaction decisions can impact investors. An investor who purchased $10,000 worth of the fund on November 5, 2020 and sold less than a month later on December 4 would have lost $581 despite Bitcoin gaining over 24% over the period.
Purchasing at different intervals may have led to increased profit or loss in excess of the underlying assets. Investors need to worry about price movements in the fund as much as they worry about the price of Bitcoin. The additional risk of these swings is not compensated by additional expected returns.
Source: 3iQ, December 31, 2020.
Purchasing the fund on different days would have led to different prices paid for Bitcoin. Looking at the chart below, the cost of exposure varies both on market conditions and demand.
The underlying mechanism leading to a premium or discount is the inability to accurately match supply with demand. Bitcoin has a robust market that closed-end funds simply cannot tap. The largest price decline in Bitcoin’s young history pre-dates the fund shown above, but one must wonder how this mismatch might play out during a period of market stress. Changing investor sentiment can make funds riskier than the underlying portfolios they hold.
Volatility and the closed-end puzzle
Many explanations have emerged to make the closed-end puzzle palatable, seeking to explain the discount observed in most closed-end funds. Charles Lee et. al hypothesize that the market remains inefficient as arbitrageurs cannot push prices towards their intrinsic values. Cherkes, Sagi & Stanton argue that the discount is indirectly justified because closed-end funds give investors the ability to sell typically illiquid assets. While Lee, Shleifer & Thaler believe that the additional risk borne by the investor of trading at a further discount warranted the additional risk premium. Despite the many theories trying to explain why, there is one well-documented externality associated with closed fund – excess volatility.
According to one study in the American Economic Review, the average closed-end fund is 64% more volatile than its assets. Bitcoin’s annual volatility already exceeds that of many traditional financial assets. Injecting needless volatility into an already volatile asset class without excess returns contradicts thoughtful, risk-conscious portfolio construction.
The ETF advantage: Transparency, stability and accuracy
Bitcoin is an emerging asset class with a rapidly expanding body of strong empirical results. Incorporating Bitcoin into traditional portfolios has historically benefited investors’ risk-adjusted returns. With the rapid adoption of Bitcoin as an investment by institutions and investors, the future is bright.
Wrapping a revolutionary asset like Bitcoin with an inefficient and volatile structure has both hidden risks and costs. When investing in Bitcoin, it is best to purchase something that gives you what you are looking for – simply Bitcoin.
While it’s natural that closed-end funds were first to offer Bitcoin in a fund structure due to their lower regulatory standards, investors no longer need to expose themselves to the additional risks stemming from that structure. Purpose Bitcoin ETF is built to match the ever changing needs of investors and provide access to Bitcoin to the masses, whether they invest themselves or through an investment advisor.
— Josh Bubar is Vice President of Product at Purpose Investments and Mike Scott is an Analyst on the Portfolio Management team at Purpose Investments.
All data sourced to Bloomberg unless otherwise noted.
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